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1 Absorption and Marginal Costing HKDSE (2017, 6) (Cost-Volume-profit analysis) Nice Company commenced business on 1 January It produces a single product, M1. The income statement for the year ended 31 December 2016 was as follows: $ $ Sales (9600 units) 2,400,000 Less: Cost of goods sold Direct materials 300,000 Direct labour 600,000 Fixed production overheads 930,000 1,830,000 Less: Closing inventory (2400 units) 366,000 1,464,000 Add: Under-absorbed fixed production overheads 15,000 1,479,000 Gross profit 921,000 Less: Selling and administrative overheads fixed 360,000 Variable (include sales commission only) 240, ,000 Net profit 321,000 (a) Calculate the contribution margin per unit of M1. (b) Calculate the breakeven sales amount for Nice Company is considering producing an advanced model Super-M in If Nice Company produces both M1 and Super-M, the production information is estimated as follows: M1 Super-M Annual production 5,000 units 7,000 units Direct labour hour required per unit 1 10 hour 1 6 hour Machine hour required per unit hour 3 hour Fixed production overheads of 2018 are budgeted at $988,000, which mainly covers factory rent, machine maintenance and depreciation for machinery. (c) Calculate the predetermined fixed production overhead absorption rate (to 2 decimal places) for each unit of M1 and Super-M respectively, using the following cost absorption bases: (i) direct labour hours (ii) machine hours (d) Briefly explain which cost absorption basis, direct labour hours or machine hours, would you recommend to Nice Company. 116

2 (a) The contribution margin per unit of M1 Per unit $ Selling price ($2,400,000/ 9,600) 250 Less Variable costs: Direct materials [$300,000 / (9, ,400)] 25 Direct labour [$600,000 / (9, ,400)] 50 Sales commission (240,000 / 9,600) 25 Contribution per unit 150 (b) Total actual fixed costs = 930, , ,000 = 1,305,000 The breakeven sales unit for 2016 = 1,305,000 / 150 = 8,700 units The breakeven sales amount for 2016 = 8,700 x 250 = $2,175,000 (c) (i) The predetermined fixed production overhead absorption rate per direct labour hour = $988,000 / (1/10 x 5, /6 x 7,000) = $592.8 per direct labour hour The predetermined fixed production overhead absorption rate for each unit of M1 = $592.8 x 1/10 = $59.28 per unit The predetermined fixed production overhead absorption rate for each unit of Super-M = $592.8 x 1/6 = $98.8 per unit (ii) The predetermined fixed production overhead absorption rate per machine hour = $988,000 / (4/5 x 5, /3 x 7,000) = $114 per machine hour The predetermined fixed production overhead absorption rate for each unit of M1 = $114 x 4/5 = $91.2 per unit The predetermined fixed production overhead absorption rate for each unit of Super-M = $114 x 2/3 = $76 per unit (d) I would recommend machine hours as the cost absorption basis to Nice Company. As production requires much more machine hours than direct labour hour, machine hours are a stronger cost driver of manufacture overheads. 117

3 HKDSE (2016, 7) (Absorption and Marginal costing) Anson Company started to manufacture a toy plane, Hippo, as its only product line in It uses the absorption costing system. The cost information for Hippo is given below: $/unit Direct materials 18 Direct labour 12 Total manufacturing overheads 6 (i) The total manufacturing overheads include both variable and fixed manufacturing overheads, based on the production of 10,000 units of Hippo each year. (ii) Fixed manufacturing overheads for 2015 were estimated to be $40,000, which was the same as the actual amount. (iii) The company hired two salesmen for a total annual salary of $128,000 to sell Hippo. On top of the salary, there was an incentive payment to the salesmen of 5% of sales (iv) Hippo was sold at a selling price of $60 per unit. (v) The actual production and sales of Hippo for 2015 were 10,000 units and 9,000 units respectively. The company is considering using the marginal costing system. (a) Prepare for Anson Company the income statement for the year ended 31 December 2015 using the marginal costing system. Show separately the contribution and the net profit. (b) (i) Calculate the amounts of inventory as at 31 December 2015 under the marginal and absorption costing systems respectively. (ii) Explain the reason for the difference in the amounts of inventory in (b)(i) above. (c) Compare the net profits of 2015 under the marginal and absorption costing systems. (a) Anson Company Income Statement for the year ended 31 December 2015 using marginal costing $ $ Sales (9,000 $60) 540,000 Less: Variable cost of goods sold: Direct materials (10,000 $18) 180,000 Direct labour (10,000 $12) 120,000 Variable manufacturing overheads (10,000 $2) (W1) 20, ,000 Less Closing inventory [1,000 x (320,000 10,000)] (32,000) 288,000 Product contribution margin 252,000 Less Variable non-manufacturing overheads ($540,000 x 5%) 27,000 Total contribution margin 225,000 Less: Fixed manufacturing overheads 40,000 Fixed non-manufacturing overheads 128, ,000 Net profit 57,000 Variable production overheads per unit = (10,000 x 6 40,000)/10,000 = $2 118

4 (b) (i) Under the marginal costing system, The amounts of inventory as at 31 December 2015 = $32,000 Under the absorption costing system, The amounts of inventory as at 31 December 2015 = $32, ,000 x $40,000/10,000 = $36,000 (ii) Under marginal costing, only variable costs are included in the cost of production and the fixed manufacturing overheads are written off as period costs. However, under absorption costing, fixed and variable manufacturing overheads are both recognized as the cost of production, thus the fixed manufacturing overheads will be absorbed by the closing inventory. (c) The difference in closing inventory under the marginal and absorption costing = $36,000 $32,000 = $4,000 The net profit of 2015 under absorption costing is higher than that under marginal costing by $4,

5 HKDSE (2015, 3) (Absorption and Marginal costing) Ivan Company had the following cost information for 2014: Beginning inventories: $ Direct materials Work in progress Finished goods Carriage inwards on direct materials Direct materials purchases Direct labour Ending inventories: Direct materials Work in progress Finished goods Production overheads Calculate the following items for 2014: (a) Cost of direct materials consumed (b) Prime cost (c) Cost of goods manufactured (d) Cost of goods sold (a) Cost of direct materials consumed = Opening inventory of Direct materials + Direct materials purchases + Carriage inwards on direct materials Closing inventory of Direct materials = $30,000 + $140,000 + $20,000 $55,000 = $135,000 (b) Prime cost = Cost of direct materials consumed + Direct labour = $135,000 + $380,000 = $515,000 (c) Cost of goods manufactured = Prime cost + Production overheads + Opening work-in-progress Closing work-in-progress = $515,000 + $330,000 + $18,000 $33,000 = $830,000 (d) Cost of goods sold = Cost of goods manufactured + Opening Finished goods Closing Finished goods = $830,000 + $48,000 $38,000 = $

6 HKDSE (2014, 7) (Absorption and Marginal costing) Goodwork Company uses the job costing system and applies a plant-wide production overhead absorption rate based on direct labour hours. The predetermined rate for the year ended 31 March 2014 was $7.0 per direct labour hour. The actual total production overheads and total direct labour hours for the year were $1,100,000 and 180,000 hours respectively. (a) Calculate the under- or over-absorption of production overheads of Goodwork Company for the year ended 31 (b) March Despite the inevitable occurrence of under- or over-absorption of production overheads, a predetermined overhead rate is more commonly used than an absorption rate based on actual data. Explain why. The following data relate to the two production departments of Goodwork Company for the coming year, which will end on 31 March 2015: Department A Department B Total material cost $300,000 $100,000 (of which 30% is direct materials) Total labour cost $820,000 $530,000 (of which 80% is direct labour) Factory depreciation $339,000 $66,000 Other indirect expenses $126,000 $24,000 Normal activity (direct labour hours) 100,000 hours 70,000 hours (c) Calculate (to one decimal place) the plant-wide production overhead absorption rate of Goodwork Company for the year ending on 31 March Two job orders, Job #103 and Job#104, have been scheduled for the coming year. The direct labour usage is estimated as follows: Department A Department B Job #103 1,000 hours 3,000 hours Job #104 3,300 hours 1,100 hours (d) Calculate the overhead cost to be assigned to each of the two job orders using the plant-wide production overhead absorption rate obtained in (c) above. Goodwork s plant manager heard that departmental production overhead absorption rates could be better for cost assignment than a plant-wide rate. (e) Based on the estimated direct labour usage of job #103 and Job #104 above, explain whether departmental overhead rates or a plant-wide rate will provide a fairer overhead assignment. Support your answer with calculations. 121

7 HKDSE (2014, 7) (Job Costing) (a) The predetermined total production overhead = 180,000 x $7.0 = $1,260,000 The actual total production overheads = $1,100,000 The over-absorption of production overheads = $1,260,000 $1,100,000 = $160,000 (b) Some overheads cannot be ascertained until the end of a year, e.g., depreciation, year-end bonuses. Many businesses do not wait until all the overheads are ascertained at the end of a year. Therefore, a predetermined overhead rate is more commonly used than an absorption rate based on actual data (c) Department A Department B Indirect material cost $210,000 $70,000 Indirect labour cost $164,000 $106,000 Factory depreciation $339,000 $66,000 Other indirect expenses $126,000 $24,000 Total production overhead $839,000 $266,000 The plant-wide production overhead absorption rate = ($839,000 + $266,000) / (100, ,000) = $6.5 per direct labour hour (d) The overhead cost of Job #103 = $6.5 x (1, ,000) = $26,000 The overhead cost of Job #104 = $6.5 x (3, ,100) = $28,600 (e) Under the departmental overhead rates, The production overhead absorption rate of Department A = $839,000 / 100,000 = $8.39 per direct labour hour The production overhead absorption rate of Department B = $266,000 / 70,000 = $3.8 per direct labour hour The production overhead absorption rate of Department A is much higher than Department B and the direct labour hour usage of Job #104 in Department A is much higher than Job #103. Hence, the departmental overhead rates will provide a fairer overhead assignment than the plant-wide rate. The overhead cost of Job #103 = $8.39 x 1,000 + $3.8 x 3,000 = $19,790 The overhead cost of Job #104 = $8.39 x 3,300 + $3.8 x 1,100 = $31,

8 HKDSE (2013, 3) (Absorption and Marginal costing) Hansan Ltd undertakes electrical work according to customers requirements. It has prepared the following budgeted information for the year 2014: Direct material cost 500,000 Direct labour cost 2,850,000 $ Production overheads 780,000 Administrative overheads 400,000 Budgeted activity levels include: Machine hours Direct labour hours 5,000 hours 60,000 hours Hansan Ltd uses a plant-wide predetermined production overhead absorption rate based on direct labour hours to allocate production overheads to jobs. (a) Calculate the predetermined production overhead absorption rate for the year (b) State one rationale for Hansan Ltd s choice of using the existing absorption base to calculate its predetermined production overhead absorption rate. The company has to price a job that would be started and completed in Information relating to the job is as follows: (i) Direct materials: $250 per metre. 100 metres are required. (ii) Direct labour Electricians: $60 per hour. 200 hours are required. Apprentices: $35 per hour. 300 hours are required. Administrative overheads are allocated to the job based on 25% of production cost. The company maintains a net profit margin of 50%. (c) Calculate the selling price of this job, showing separately the amount of: prime cost production cost total cost HKDSE (2013, 3) (Job Accounting) (a) The predetermined production overhead absorption rate = $780,000 / 60,000 hours = $13 per direct labour hours (b) As production of jobs in the company is labour-intensive the best measure of overhead resources consumed by each job is direct labour hours Since the company is a electrical work company, it uses much labour to carry the work. This can be shown on the information of direct labour cost. The amount of the cost is greater than other cost very much. Therefore, use direct labour hours as the absorption base is suitable for the company. 123

9 (c) Job cost card $ $ Direct materials ($250 x 100) 25,000 Direct labour ($60 x $35 x 300) Electricians ($60 x 200) 12,000 Apprentices ($35 x 300) 10,500 22,500 Prime cost 47,500 Production overhead ($13 x 500) 6,500 Production cost 54,000 Administrative overheads (54,000 x 25%) 13,500 Total cost 67,500 Profit 67,500 Selling price 135,000 $ $ Prime cost Direct materials ($250 x 100) 25,000 Direct labour ($60 x $35 x 300) 22,500 47,500 Production overhead ($13 x 500) 6,500 Production cost 54,000 Administrative overheads (54,000 x 25%) 13,500 Total cost 67,500 Selling price (67,500 / 50%) 135,

10 HKDSE (2012, 4) (Absorption and marginal Costing) Magic Company manufactures and sells a single product, Product X. For the purpose of preparing the budget for Product X for the month of November 2012, the following information is provided: (i) The budgeted production and budgeted sales for the month are 5000 and 4400 units respectively. (ii) The expected selling price is $300 per unit. (iii) The direct material cost of the production is $40 per unit. An additional transportation cost of $2 per unit is to be incurred for the purchase of the direct materials. (iv) Each unit of product requires 2 hours of direct labour. The hourly rate of direct labour is $60.5. (v) The production overheads of the product comprise a fixed and a variable element. It is the company s policy to apportion variable production overheads in relation to the number of units produced. Assuming the monthly fixed production overheads of the company remain the same in 2012, the annual budgeted production overheads will be $ if units are produced each year, and $ if units are produced each year. (vi) Selling and distribution expenses consist of a sales commission of $8 per unit sold and a fixed monthly distribution expense of $ Magic Company adopts the marginal costing system. Assume it does not keep any inventories as at 31 October 2012, calculate the following for Product X for the month ended 30 November 2012: (a) the budgeted total value of closing inventories (b) the budgeted total amount of contribution (c) the budgeted total amount of net profit (a) Budgeted total value of closing inventories $ Direct materials cost per unit 40.0 Transportation cost on direct materials per unit 2.0 Direct labour cost per unit ($60.5 x 2) Variable production overheads per unit [($ $ ) / ( )] 5.5 Total variable cost per unit Unit of closing inventories ( ) (b) Budgeted total amount of contribution $ Sales price per unit 300 Less Total variable cost per unit Sales commissions per unit 8 Contribution per unit Number of unit sold (c) Budgeted total amount of net profit $ Total amount of contribution Less Fixed production overhead ($ $5.5 x )/ Fixed monthly distribution expense

11 HKDSE Sample 2 (Paper 2A, 2) (Absorption and marginal Costing) Perry Ltd started producing Product A on 1 January The unit selling price and cost of Product A for the month of January 2012 were as follows: ($/unit) Selling price 5.90 Direct material 1.20 Direct labour 1.40 Variable production overheads 0.70 Variable selling and administrative expenses 0.15 (i) Fixed production overheads were budgeted at $308,000 per month and were absorbed based on the number of units produced. Actual fixed production overheads of Product A were the same as the absorbed fixed production overheads for the month. (ii) Budgeted production and budgeted sales were the same at 280,000 units per month. (iii) Actual production and actual sales of Product A for the month were 250,000 units and 220,000 units respectively. (iv) Actual fixed selling and administrative expenses were $110,000. (v) There were no closing direct materials and work-in-progress inventories of Product A as at 31 January (a) Prepare the income statement for the month ended 31 January 2012 using absorption costing. (b) As compared with the absorption costing system, advise Perry Ltd two advantages of using the marginal costing system. (a) Perry Ltd Income Statement for the year ended 31 January 2012 using absorption costing $ $ Sales (220,000 $5.90) 1,298,000 Less: Cost of goods sold: Direct materials (250,000 $1.20) 300,000 Direct labour (250,000 $1.40) 350,000 Variable production overheads (250,000 $0.70) 175,000 Fixed production overheads absorbed (250,000 $1.1) 275,000 1,100,000 Less: Closing inventory [(250, ,000) x $4.4] 132, ,000 Gross profit 330,000 Less: Variable selling and administrative expenses (220,000 x $0.15) 33,000 Fixed selling and administrative expenses 110, ,000 Net profit 187,000 Unit fixed production overheads absorbed = $308, ,000 = $1.1 Unit production costs under absorption costing = ($ $ $ $1.1) or ($1,100, ,000) = $4.4 (b) Advantages: inventory valuations will not be distorted by the changes in current year s fixed costs enables the company to concentrate on its controllable aspects by separating its fixed and variable costs helps management to make production and sales decisions with the calculated marginal costs information 126

12 (a) Perry Ltd Income Statement for the year ended 31 January 2012 using marginal costing $ $ Sales (220,000 $5.90) 1,298,000 Less: Cost of goods sold: Direct materials (250,000 $1.20) 300,000 Direct labour (250,000 $1.40) 350,000 Variable production overheads (250,000 $0.70) 175, ,000 Less: Closing inventory [(250, ,000) x $3.3] 99, ,000 Product contribution margin 572,000 Less: Variable selling and administrative expenses (220,000 x $0.15) 33,000 Contribution 539,000 Less: Fixed production overheads absorbed (250,000 $1.1) 275,000 Fixed selling and administrative expenses 110, ,000 Net profit 154,000 Unit fixed production overheads absorbed = $308, ,000 = $1.1 Unit production costs under absorption costing = $825, ,000 = $

13 HKDSE (sample, 3) (Absorption and marginal costing) Lau Yan Manufacturing Company has extracted the following information as at 31 December 20X6 $ Inventories as at 1 January 20X6: Raw materials 40,800 Work in progress 35,000 Finished goods 180,000 Royalties (based on the number of units produced) 89,000 Depreciation charge for the year: Plant and machinery 90,200 Delivery vehicles 897,560 Office equipment 65,377 Direct labour 60,800 Purchase of raw materials 170,000 Factory manager s salary 57,000 Rent and electricity 112,500 Administrative and selling expenses 87,300 Materials loss due to fire 50,000 Additional information: (i) At 31 December 20X6, inventories were valued as follows: $ Raw materials 77,000 Work in progress 52,000 Finished goods 175,000 (ii) It is the company s policy to apportion two-thirds of the costs common to both the factory and the office to the cost of production. (iii) Finished goods are transferred to the sales department at cost plus 10%. (a) Prepare the manufacturing account for the year ended 31 December 20X6 (b) Ascertain each of the following for the year ended 31 December 20X6 (i) Cost of raw materials consumed (ii) Prime cost (iii) Production cost of finished goods (iv) Transfer price of finished goods 128

14 (a) Cost of raw materials consumed = $40,800 + $170,000 ($77,000 + $50,000) = $83,800 (b) Prime cost = $83,800 + $89,000 + $60,800 = $233,600 (c) Production cost of finished goods = $233,600 + ($112,500 x 2/3 + $90,200 + $57,000) + $35,000 $52,000 = $438,800 (d) Transfer price of finished goods = $438,800 x (1 + 10%) = $482,680 Lau Yan Manufacturing Company Manufacturing Account for the year ended 31 December 20X6 $ $ Opening inventory of raw materials 40,800 Add: Purchases 170, ,800 Less: Fire Loss 50, ,800 Less Closing inventory of raw materials 77,000 Cost of raw materials consumed 83,800 Direct labour 60,800 Royalties 89,000 Prime cost 233,600 Factory overheads: Rent and electricity ($112,500 x 2/3) 75,000 Depreciation of Plant and machinery 90,200 Factory manager s salary 57, , ,800 Add Opening work-in-progress 35, ,800 Less Closing work-in-progress 52,000 Production cost of finished goods 438,800 Mark up (10%) 43,880 Transfer price of finished goods 482,680 (a) Cost of raw materials consumed: $83,800 (b) Prime cost: $233,600 (c) Production cost of finished goods: $438,800 (d) Transfer price of finished goods: $482,

15 HKDSE (sample, 9) (Absorption and marginal costing) Mary is a fresh university graduate who has majored in marketing. She is enthusiastic about conducting a business of her own alongside her full-time employment. She borrowed a sum of $90,000 from a bank at an interest rate of 5% per annum on 1 January 20X7 to run a shop which sells free-sized T-shirts of her own design. Information relating to the shop is as follows: (i) The shop s rental is $5,000 per month. The annual rates and insurance expenses are $3,600 and $4,500 respectively. (ii) A shop attendant is hired at a basic salary of $7,000 per month plus a commission of 5% of the sales value. (iii) All T-shirts are imported from factories based on the Mainland and are sold at 100% mark-up on cost. (iv) The budgeted sales volume is 500 shirts per month. Mary has made arrangements with the Mainland suppliers for the supply of 500 shirts each month. Then a logo sticker will be fixed on each shirt by a sewing service provider nearby at the cost of $2 each. The purchase costs for the first quarter of 20X7 are as follows: $ January 20X7 22,500 February 20X7 24,000 March 20X7 25,000 (v) In order to publicise her new brand, Mary will print some promotional leaflets to be distributed once a week in the neighborhood. The printing cost of the leaflets amounts to $500 per month and a part-time worker is hired at $1,000 per month for the distribution work. (vi) A point-of-sale system costing $30,000 was purchased to help keep inventory record and cash transactions. In addition, Mary furnished the shop with necessary furniture and fixtures by spending a further $60,000. Depreciation is to be calculated at 12% per annum on a reducing balance basis for the point-of-sale system and 10% on cost for the furniture and fixtures. (vii) The actual sales figures for the first quarter ended 31 March 20X7 are as follows: (a) Number of shirts January 20X7 350 February 20X7 420 March 20X7 400 Define direct costs and indirect costs and identify one example for each from the case above. (b) (c) (d) Compare marginal costing with absorption costing with respect to inventory valuation and income determination. Prepare an income statement for the first quarter ended 31 March 20X7 using the marginal costing method, assuming the FIFO method is adopted in the valuation of unsold goods. With the figures you have compiled in (c) above, calculate the breakeven point (in sales dollars) of the first quarter ended 31 March 20X7. Noting that there are several giant enterprises in the low-margin garment market, Mary s father has always persuaded Mary to discontinue her small business which is unlikely to be competitive enough to survive. (e) Discuss two possible reasons why Mary is still enthusiastic about running a business of her own. 130

16 (a) Direct costs costs that would be economical to trace their cost object e.g. purchase cost, cost of stickers, sales commission Indirect costs costs that would not be economical to trace their cost object e.g. printing cost, salaries, rent and rates, insurance, depreciation (b) Inventory valuation Income determination Marginal costing Only variable costs are charged to units. Fixed costs incurred will not be carried forward and the profit of the current accounting period will be lower. Absorption costing Fixed costs are treated as product costs and can be carried forward to the next period in the value of each unit. A proportion of the fixed costs of the current period will be carried forward to the next accounting period and therefore the profit of the current accounting period will be higher. (c) Income statement for the first quarter ended 31 March 20X6 $ $ Sales [($22,500 + $24, x $50) x 200%] 110,000 Opening inventories Purchases ($22,500 + $24,000 + $25,000) 71,500 Logo stickers (1,500 x $2) 3,000 Less Closing inventories [( ) x ($50 + $2)] (17,160) 57,340 Product contribution margin 52,660 Less Variable costs: Commission ($110,000 x 5%) 5,500 Contribution 47,160 Less: Fixed costs Rent and rates ($5,000 x 3 + $3,600 x 3/12) 15,900 Insurance ($4,500 x 3/12) 1,125 Salaries ($7,000 x 3 + $1,000 x 3) 24,000 Printing costs ($500 x 3) 1,500 Depreciation [$30,000 x 12% x 3/12 + $60,000 x 10% x 3/12] 2,400 44,925 Net profit 2,235 (d) Total fixed costs = $44,925 Contribution margin ratio = $47,160 $110,000 Breakeven sales dollars = Fixed cost Contribution margin ratio = $44,925 / ($47,160 $110,000) = $104,787 (e) a platform for self-actualization: the business provides an outlet for Mary to introduce products of her own design a form of investment: the rate of return on her business has reached 8%, which is higher than the market interest rate an opportunity for self-development: Mary will acquire management skills by developing her business strategies and job design in real situations a way to serve the public: Mary may target the needs or interests of minority groups that may well not be served by giant enterprises. 131

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